 # interest rate put vs. call calculation

i don’t understand this… the math is fine, but why do you add the future value of the put premium to the denominator in the EAR calculation? i understand that you subtract the future value of the call premium because it represents an outflow – you bought the call. but aren’t you long the put as well? shouldn’t you also subtract the put from the denominator?

asdffdsa Wrote: ------------------------------------------------------- > i don’t understand this… > > the math is fine, but why do you add the future > value of the put premium to the denominator in the > EAR calculation? i understand that you subtract > the future value of the call premium because it > represents an outflow – you bought the call. but > aren’t you long the put as well? shouldn’t you > also subtract the put from the denominator? because that is the cost you are incurring, that is your cash outflows

ya, you bought a put, you are long - you’re correct on that. BUT ou are the one lending hte money and you buy the put as interest rate insurance. So that represents an outflow for you but since you are lending hte money, what you are getting is inflows but the amount of inflows in total will be smaller by the cost of the put. That’s why you add the cost of the put into your denominator since buying hte put reduces your EAR.

oh, i see, so the for the side earning the EAR you add the put (protect minimum return) to the denominator because it represents a use of cash (ie the hedge reduces your EAR because more capital is committed). with the call, you are BORROWING the money, so you reduce the denom because the future value of the call premium reduced the value of your loan. so your EAR is based on the lowered loan capital amount (loan - adjusted call premium) i think that’s right, please confirm. thanks.

almost correct. you said: " because the future value of the call premium reduced the value of your loan" you should have said: “because the future value of the call premium could have reduced the value of your payments” but ya, i think you got the concept now.

For borrow, you subtract For lender, you add.